Liability driven investment - portfolio institutional...Liability driven investment (LDI) continues...

2 August 2013 portfolio platform Liability driven investment

Mike WalshHead of UK distribution,

Legal & General Investment Management

Opkar SaraPrincipal fund manager,

Pension Protection Fund

Kenny NicollDirector, manager research team,

Redington

August 2013 portfolio platform: Liability driven investment 3

Brian McCauleySenior investment consultant,

Buck Global Investment Advisors

Roy SampsonFinance director,

Groupama Insurance

Raymond HainesHead of EMEA strategy and research,

State Street Global Advisors

Sebastian CheekDeputy editor,

portfolio institutional


Keeping an eye on the bigger picture

Liability driven investment (LDI ) continues to grow in the UK market, with KPMG’s latest

annual LDI survey suggesting the strategy grew by 11% in 2012, accounting for £446bn in

liabilities across 686 pension scheme mandates.

But with gilt yields at an all-time low, LDI has been forced to evolve. Traditionally, LDI used

straightforward swaps and gilts to match a pension scheme’s liabilities, but with liabilities

having been pushed up by a combination of quantitative easing and accounting regulation,

strategies have been forced to keep pace with the changes by utilising more technical

derivatives and market-based triggers which take the emotion out of the decision-making

process.

The ‘new age’ LDI is sophisticated, complex, more tailored to specific needs and requires

an additional layer of governance from scheme trustees, particularly at the smaller end of

the scale. Many believe as LDI evolves it is no longer just about hedging liability risk, but

more a holistic risk management solution encompassing the hedging of equity, currency and

longevity risk.

Elsewhere, forthcoming regulation around central clearing of over the counter derivatives is

another headache for trustees running LDI strategies as it is not yet clear what the knock-on

effect in terms of the cost of hedging will be.

But with gilt yields looking set to stay low for the short to medium-term, what happens if/

when these yields normalise and sophisticated LDI strategies start to unravel? How easily and

quickly can trustees revert to a more traditional LDI strategy?

Also, given the time constraints placed on trustees and investment sub-committees, how

can trustees best approach LDI? Is this kind of sophisticated strategy perhaps best left to a

fiduciary manager?

This portfolio platform assembles a group comprising asset managers, consultants and

investors to debate the issue. The panel discusses the evolution of LDI, the ef fect of changing

derivative regulation and the timing and governance issues schemes face when implementing

an LDI strategy.

Sebastian Cheek

deputy editor, portfolio institutional

Sebastian Cheek


A recent KPMG report showed liability driven investment (LDI) grew 11% in 2012, and now

covers £446bn of UK scheme liabilities across 686 UK pension scheme mandates. With gilt

yields at all-time lows, LDI has been forced to evolve. It’s no longer using just gilts and swaps to

match liabilities, so where do you see LDI developing?

Walsh: The first LD I strategy we put in place was 13 years ago and very much focused on matching

cash flows – interest rates and inflation risk. The mandates we work on today have moved from being very

interest rate and liability focused to complete, holistic risk management, so it covers the liabilities, but also

equity risk, currency risk, and also longevity risk, too. LDI is really the wrong phrase; it’s moved away from

LDI and it’s actually risk management solutions.

Nicoll: There’s certainly a move to having a risk budget. A lot of people now are not prepared to take that

amount of risk on one underlying but want to spread it around to credit, to equities, to FX and commodi-

ties. So there’s more of a movement to have risk premiums in more than one place.

Haines: LDI was always a misnomer, because it has always been about objective-based investing,

whereas LDI was lumped in as being rates and inflation hedging. That’s not what it was really about,

because it was never a solution. It was only ever part of the solution.

You are now going back to what investment managers and trustees always wanted: to achieve the objec-

tive, namely meeting the liabilities as quickly as possible and as safely as possible. From the sponsor’s

point of view, the same, but as cheaply as possible.

Sara: We see LDI very much as part of the solution. It helps us understand the risk framework in which

we operate. Our objectives are to meet the liabilities over the years that we have them. LDI is just one

methodology; there are others out there as well, but LDI helps us effectively frame the decision. It helps us

“The mandates we work on today have moved from being very interest rate

and liability focused to complete, holistic risk management. It covers liabilities,

but also equity risk, currency risk, and also longevity risk.” Mike Walsh

Mike Walsh


ultimately to make better decisions about where we want to place our risks. We understand those risks

better because we use an LDI framework.

McCauley: Also, it’s accessible to a wider client base and it’s not an exclusive club anymore.

How has it become more successful for smaller schemes?

McCauley: The product offering has broadened, the selling off of the pooled vehicles, ratio buckets and

the rest of it. That has really helped and there are far fewer excuses, now, for the client base not to be

aware of the risks.

Walsh: I’d agree. The product set was very much accessible only to the large pension schemes. You’ve

now got an array of pooled funds that manage lots of risks, not just the interest rates, but also equity

risks. Trustee understanding of the governance issues has also provided a framework for smaller pension

schemes to understand some of the tools that the asset managers are bringing to the table.

Nicoll: We like the idea of visibility, but it does come back to having the framework, and the trustee and

the sponsor buying in to what we’re going to do.

In terms of smaller clients, it has become more accessible, but the number of trading partners has devel-

oped. The product suite they have developed, as well, is a symbiotic relationship between the buy and

sell side. That makes it easier to get rid of the risk, if you’re the investment manager.

Sara: LDI tells you if you incorporate the liability side of the balance sheet in the equation, the risk is not as

small as perhaps you thought. That’s the first elementary step, then you move on from that, because LDI

can be complex. The barriers have come down, simply because many more people are using it. This has

raised awareness, but complexity has increased. As a professional working in the LDI space, you need

Raymond Haines

“Some of the changes in the regulatory regime around derivatives – how they

are cleared, priced, etc – will have big ramifications for defined benefit pension

schemes.” Raymond Haines


greater knowledge of more instruments and how they operate within that sphere.

Sampson: In the non-life industry, we’ve seen a lot more focus on a new solvency regime, and there’s a

lot more focus on risk and risk assessment. Not just the insurance risk, but the investment risk as well,

so we’re seeing a lot more LDI than before. The other reason is periodic payment orders (PPOs), which

are beginning to come in to replace serious injury – instead of paying a one-off payment to injured parties,

there’s an agreement with the courts that you pay it over the lifetime of the claimant. Sometimes a claim

has a capitalised value of £14m, and now we’ve got to pay that over a period of 50 years.

Haines: One of the issues LDI is going to face over the next few years is the change in the regulatory

regime around derivatives – how they are cleared, priced, etc. Some of the changes will have big ramifica-

tions for defined benefit (DB) pension schemes. The margin requirement on a 30-year interest rate swap

is going to be horrendous compared to what we had before when we were individually collateralising.

Walsh: Central clearing is something that is now very much on the agenda for many of our clients and

clearly this has implications which need to be considered. You remove the counterparty risk but one of the

downsides is that you need to hold more cash collateral for exchange traded derivatives.

What are the likely knock-on effects on LDI?

Walsh: Central clearing would removing some of those risks and allow trustees to go back to focusing

on the bigger picture.

Sara: One of the concerns we have, is what the likely cost of hedging will be. That is not clear yet. The

cost is related to the collateral; effectively, the opportunity cost of foregoing gilt returns and replacing that

with cash returns. What do you do in order to make up that lost return? LDI still provides the solution to

that, but the parameters will change within the LDI framework we have, though it’s not really an LDI frame-

work, but a risk framework that we use in order to define our objective.

Haines: Basically it becomes holistic balance sheet management. The best execution doesn’t simply

mean getting the best price – it’s the best use of the capital, how you fund a particular position and how

you actually offset one set of margins with another set of arbitrary margins.

Could we see a rush to put these hedges in place before clearing regulation comes into play?

Nicoll: You’re making the tail wag the dog. I wouldn’t deviate massively from the flight path you think

you’re going to be on in terms of your funding. Our rule of thumb is, if you are 80% funded then roughly

you’ll be 80% hedged, because it keeps the required rate of return you generate from the other assets,

roughly stable. By going beyond that boundary of that rule of thumb by 3%, 4%, or 5% and you’re start-

ing to put more risk on the table than you really need to. There will be a cost in terms of the swaps, but I

wouldn’t unbalance my portfolio to avoid it.

Opkar Sara Kenny Nicoll


Could it push up the costs of hedging?

Haines: Undoubtedly it’s going to cost more. It’s just a question of what

those costs will be, and estimates range from the sublime to the ridicu-

lous. It depends on whether you want to put the fear of God into trustees

and managers or not.

Sara: The point is you’re getting something for that cost; hopefully re-

duced counterparty risk. So you could think of it as a premium you’re

paying to reduce risk somewhere within the portfolio.

Should schemes wait to implement an LDI strategy, or is now a

good time to put one in place?

Sampson: From our perspective, LDI can be a very dangerous strategy.

Mathematically, it’s very objective; it’s very attractive for people to play across the board, not necessarily

where it’s appropriate. So where it’s a closed fund or there is a specific requirement I think it’s wholly ap-

propriate, but in non-life insurance, where there’s not a natural duration of liabilities, people are investing

in an LDI strategy at historically low yields. This may look good from a pure risk perspective, but is going

to have a commercial cost as and when the risks spike up, say, the next two or three years.

Walsh: The answer is different for every client. The first question you have to ask is how big a short posi-

tion are you running in interest rates or inflation? If you lock in at low yields, you don’t get the benefit of

yields rising on the assets site, but clearly, if you’re running a 70%, 80% short position versus your liabili-

ties, taking some of that risk off the table is a good thing. You will still gain the benefit from the non-hedge

portion of your liabilities, etc.

As more people understand LDI and start to quantify the risks in their schemes, they’ve seen how big

a short position they’re running, and we’re finding even at current levels, clients are taking some of that

risk off the table, because it’s just such a large bet that outweighs everything else they’re doing in their

scheme.

Haines: Japan has proved that rates can stay lower for longer than anybody anticipates, and it’s not so

long ago that the concept of negative real rates was something that was unthinkable. But they did across

the entire curtain. It’s a question of knowing where you are today and where you want to go, and if you’re

20% hedged, then the only way is up, and even if you’re doing it progressively over time, it makes sense

to do something. If you’re 90% hedged and in a fully-funded scheme,

then the possibility of being patient and waiting for a better opportunity

is clearly there.

Nicoll: You’ve made a really good point about portfolio theory. Quite a

lot of things about a swap or putting a hedge on is that, even if it doesn’t

make money, you end up with a portfolio with less risk, because you’ve

got less downside through negative inflation, at least, and you can po-

tentially take more risk whether it’s on credit spreads or somewhere else.

People are obsessed with trying to lock in at the best price. I’m not

sure that’s really the best way to think about it. The cost of doing that in

swaps right now is about 2.5% of your liabilities, every year you don’t

hedge, and if you’ve got a gilt benchmark, it’s about 3.5%. It’s basically

a basis point a day. That’s the cost of waiting. So if you don’t want to do

a hedge, and you want to put your money in equities, bear in mind they

have got to make 3.5% more just to stand still if rates don’t go up.

McCauley: Pension schemes shouldn’t be facing a binary decision. There’s a flight plan framework, and

there’s a danger if we start getting clients who think they will hedge at a certain number. But that aware-

ness of how sensitive funding levels are to the rates, the volatility in having than plan and awareness is, in

Brian McCauley

Roy Sampson


my mind what it’s all about.

Walsh: Over the past three to four years, many more clients haved moved to market-based triggers for

part of their hedging. But they have a greater focus and understanding of what’s happening on the funding

level, so that is one of the reasons LDI has grown so much.

Sara: And also reduce the volatility of the funding level, which is quite important. From our perspective it’s

about understanding what risk you have in the interest rate space. That’s just one of the risk premiums

out there and we would balance that with other risk premiums we see, such as equity risk premiums and

other alternative risk premiums.

So should there be triggers in place?

Walsh: Triggers based on funding level, perhaps. The problem is moving the consensus away from trying

to call the markets in overcomplicated market triggers. There are plenty of schemes out there that have

a very complex structure, but it must be remembered to keep an eye on the big picture, which is your

funding level.

Nicoll: If you do part of your hedge and you hedge your funding ratio, you’re at least swapping market

view for diversification. The brilliant thing about diversification is, if you get your market view wrong, diver-

sification saves you. Also, by watching the volatility of the portfolio, if you get your diversification wrong,

changing your diversification when it gets too volatile will save that. Market-based triggers was a great

Opkar Sara

“LDI helps us effectively frame the decision and ultimately make better

decisions about where we want to place our risks.”

Opkar Sara


idea when we were in a more stable interest rate environment, but you couldn’t apply these after 2008.

McCauley: Don’t forget from an investor’s perspective, they’re unrewarded risks, so they’re not client

interest rates. They’ll hurt on the way down, but they’re not getting rewarded, so why take the risk?

Walsh: The consensus to get around is that once you set your strategy, know how much you’re hedging

and are phasing into it, you don’t miss the opportunity; it’s not all based around triggers.

But to be fair, some of the market-based triggers are a real tie-in, so what you’re trying to do is, if there’s

a spike in rates, take advantage of it. The other, more simplistic way, is to phase your hedging in, so over

the long term, you actually take advantage of the change in reals.

Haines: You have to be very careful of spurious accuracy, too. If you were using a fund’s price for a

smaller scheme, and you’re looking at things on a real-time basis, by the time you actually implement a

trade, you’re looking at forward pricing anyway. That can introduce an element of complexity.

Sara: I’d echo the point about simplicity; having simple trading rules going in and out based on fund-

ing levels would be fine too. Just always be wary that sometimes you don’t get it right, understand the

stresses, but as long as you understand exactly where the risks lie, discipline should help you reduce the

risks around that.

Haines: Diversification is a good thing in principle, and it’s something that we all believe and do, but what

2007-2008 proved was that diversification works until it stops working, and when it stops working, there

is nothing you can hold to do that.

Is there one particular risk that needs to be hedged, or has greater priority than another?

Sara: Theoretically, if you’ve got a broadly balanced portfolio of assets, then it should be indifferent be-

“We like the idea of visibility, but it does come back to having the framework,

and the trustee and the sponsor buying in to what we’re going to do.”

Kenny Nicoll


tween all of those risks. At the PPF, we would go through stress scenarios and try to determine what the

highest impact events are and the probability of them happening. The first line of defence is diversification.

The second line of defence is outright insurance. It’s the insurance event that we would consider putting

on tail risk hedges. The success of that approach is based not on a return metric, but the cheapest cost

of hedging relative to the amount of risk reduced.

Walsh: The PPF’s knowledge of the risks in their scheme is much greater than the average pension

scheme. There’s no such thing as an average pension scheme, but for a lot of the clients we work with,

it becomes more obvious which are the big risks for them, because they’re not starting from the position

where you have a much more balanced approach to risk.

Haines: The biggest problem is the risks that you don’t know. One of the risks that hedge funds have

faced, and that’s cost them dearly over the years, has been the changes in regulation, and that is one risk

for which there is no hedging available.

Is there an optimal governance structure for managing LDI?

McCauley: It’s important to get to share with the trustees the magnitude of the risks. That’s probably

what you want to address first, and trying to bring them some sort of clarity

Nicoll: Partly it’s education or understanding, but essentially it’s having clear objectives and a framework

in place. The other thing that’s really helpful is agility – the ability to act. When a risk is too big, you then

do something about it, rather than making a call on rates.

Sara: Markets are moving real-time, and investment committees generally meet once every three months,

but the two don’t necessarily interact well.

Walsh: One of the things that LDI has done is actually a fundamental change in our industry, in terms of it

now being much more common to find us all around a table discussing risk strategy, whereas historically,

asset management was about the product.

The governance structure has moved and we’re all looking at the goal, and how you best achieve it, realis-

ing that nobody has all the right answers. You will find a more collaborative approach to risk management,

particularly in the larger schemes.

Haines: There is another development that’s fundamental and changes the way the industry will operate


over the next 10 years. It’s the move to funds becoming cash-negative, closed to new entrants, closed to

future accruals. It means that the cash flows become much more significant, and however you manage

your risk budgeting, what you have actually got is the investment is past-dependent. The requirement to

manage liquidity within the scheme is going to change; not simply for funding your LDI hedging strategies,

but your ability to pay in benefits. Two bad years could put some schemes into the PPF.

McCauley: There needs to be a much more robust framework and that whole structure needs to be really

tight, everyone be crystal clear what is going to happen, and how the decisions are going to be made.

That can be the hard bit to get to, but it works really well when you have it in place, and it takes a lot of

the emotion out of the decisions. In many cases, it will turn out to be the right thing to do.

Nicoll: Once you set out the limits and the mandate, it takes a lot of the personal view and opinion out

of it. In larger schemes, the permanent working group is making decisions much quicker and the gap

between the consultants, the manager and the trustee board, is being filled in.

Walsh: Larger clients who have CIO functions have been able to take advantage and advance the derisk-

ing strategy a lot quicker than those clients who don’t.

Where do you think interest rates and inflation are likely to go over the next five years?

Sampson: We’re in danger of seeing interest rates spike up in two or three years if quantitative easing is

maintained. There’s a great danger it’s going to catch people out.

Haines: I think they’re going to go down and up, but not necessarily in

that order.

Walsh: I’m in the business of solution de-risking, not calling where rates

and inflation are going to be, because I encourage clients to be looking

at the bigger picture, which is their funding level.

McCauley: What is interesting – and maybe scary – for pension schemes

is long-term market expectations of inflation. If it’s 3.25% or 3.5% over

the next 20, 30 years, it’s going to be significantly above that at times.

Haines: Economic models work until you have a paradigm shift, and

then they don’t and that’s exactly the situation we have gone through.

So, the econometric models that we used up until 1997/1998 were fine,

then you had to rewrite the rules. We’re still in the process of what’s

happening and it’s the unknowns that are going to cause the problems.

So, is de-risking really achievable?

Haines: The answer to that is no. Risk is a bit like energy; it’s neither created nor destroyed, it just moves

around. From a pension fund’s point of view, risk is, in a way, like an onion. When you’ve got it as a whole,

you’ve got one thing, but the more you get into it, the more levels and layers there are, and the deeper

you go into it, the more tears you will shed.

All you can do is know the risks you’re taking, quantify them and, as far as possible, mitigate those risks in

some shape or form; by diversification, by hedging rates, by hedging inflation, so that the risks that you’re

left with are the ones that you choose to take.

Walsh: It depends on your definition of de-risking. The only way to fully derisk is to pass a pension scheme

over to an insurer, but there are many steps in-between and we’re seeing is many more tools become

available. Longevity hedging is still relatively new, but some are moving on from doing the traditional risks.

Are complex strategies off-putting for trustees that you speak to, or are they ok with them as

long as they do the job?

Haines: It depends on the trustees. Some are happy to invest in pooled vehicles, which historically have

had great performance, yet they have no real concept of what’s in them. Diversified growth structures are

Raymond Haines


like that – it’s an act of faith.

Most derivatives are no more complex than most other investment vehicles; it’s just how you explain what

they are and what you’re trying to achieve with them.

Walsh: I would say ‘complex’ is probably the wrong word. They’ve become more sophisticated, but only

because the pension schemes have started to look at alternative risks to manage.

Haines: Index-linked is a case in point, because people think they are the ideal hedge for a pension liabil-

ity. Well, they aren’t really, because a pension fund liability is LPI-linked, so it has a flaw that gilts don’t. The

only derivative that properly matches an LPI liability is an LPI swap and they are an endangered species.

Sara: It’s incumbent upon the investment community to educate and create awareness. At the end of the

day, knives are dangerous, but in the hands of a surgeon they can save a life. It’s just a case of making

people aware of the risks.

Derivatives have had a bad reputation – and not just in LDI – because the risks as well as the benefits may

not have been emphasised or focused on enough.

Walsh: There is a big difference between derivatives for speculation and derivatives for risk management.

Yes, there are risks involved in all these instruments we’re talking about, but at the end of the day, we’re

trying to manage risks that are already in the scheme; there are these massive short positions that they’re

running, and these instruments are a way of reducing that risk.

Haines: Derivatives got a bad name because they were linked with leverage, basically. It was the leverage

that was a problem, not the derivative.

McCauley: All these tools should be part of a scheme’s armoury to mitigate the risk, but the policy they’re

trying to operate within needs to be clear enough to really work well.

Brian McCauley

“There needs to be a much more robust framework. That can be hard to get to,

but it works really well and takes a lot of the emotion out of the decisions.”

Brian McCauley


We recognise the governance challenge faced by many smaller pension

schemes when dealing with the area of risk management, with trustees

facing complex strategic decisions around diversification and liability driven

investment (LDI). These decisions are often made more awkward because

of the difficulty in accurately quantifying the existing risks within a scheme

or the tangible benefits of altering the investment strategy.

These issues have become more prevalent as LDI has become mainstream.

Indeed this risk management approach has become the cornerstone of

many schemes’ investment strategies, with over £446bn of liabilities being managed in this manner

according to the 2013 KPMG LDI Survey.

Strategy design

It can be difficult to envisage exactly how the investment choices made today might affect the funding

level of a scheme in the future. Smaller schemes face even greater hurdles as time, resource and

budget constraints can make more sophisticated scheme design and risk assessments unaffordable.

Smaller pensions schemes are often bombarded with new investment choices but can ill-afford to take

risks on any opaque or untested investment solutions.

Recognising and understanding these additional governance hurdles was a key driver in the

development of Legal & General Prism. This simple to use, web-based, risk management tool provides

pension schemes with access to market-leading analytics in an easy to understand format. For

example, this tool will provide trustees of smaller funds with real-time information on funding levels,

investment performance and stress test scenarios.

Seeing the bigger picture for smaller schemes

By Mike Walsh, head of UK distribution, LGIM

Dashboard Analytics Risk Curves

VaR, 1 year Monte Carlo 95%

GBP 21,242,153

Risk Analysis, GBP m

Risk attribution, GBP m

60

Scenario

Base

Equity prices, 20% decrease

Inflation, 1% increase

Inflation, 1% decrease

Interest rates, 1% increase

Interest rates, 1% decrease

Surplus / (deficit)

(18.93)

(32.11)

(26.09)

(11.65)

(2.92)

(39.30)

Movement

(13.19)

(7.16)

7.28

16.01

(20.37)

50

40

30

20

0

10

InterestRate

Inflation Equity CreditFX SwapSpread

Property Diversifi-cation

NetRisk

Valuation Summary GBP

200

At 28 Feb 2013

Assets

Liabilities

Surplus / (deficit)

Funding level

Value

126,765,100

147,690,733

(18,925,633)

87.2%

1mth change

4.3%

0.6%

4,404,139

3.1%

150

100

50

031/10/2012 30/11/2012 31/12/2012 31/01/2013 28/02/2013

Assets Buyout IAS19 Technical Provisions

Funding Level

87.2%

Valuation history, GBP m

PRISM COMPANY Change Investment StrategyAll Schemes, Buyout basis as at 28 February 2013; 1yr Monte Carlo 95% VaR

Combined BreakdownLiabilities SensitivityAssets

Prism Company Logout

Legal & General PrismImproving information, enhancing understanding


Legal & General Prism allows clients to assess how different investment strategies would perform

across market cycles and during extreme events. This tool is designed to enhance the robustness

of strategic investment decisions and improve understanding across the entire pension scheme life

cycle. It allows Trustees to quantify the impact of changing their strategy and for example adding more

diversification or liability hedging.

This should provide pension schemes with better insight which can inform debate at investment

strategy meetings and lead to greater confidence in the chosen investment strategy.

Bringing Prism to life

When Legal & General Prism is combined with pooled solutions in an affordable structure, it can

become a very powerful tool for trustees to design and implement their investment strategy.

A wide range of pooled solutions are now available that can offer schemes the ability to reduce

funding level volatility by managing inflation and interest rate exposure whilst at the same time retaining

sufficient exposure to growth assets to generate returns. Managing the risk within the growth portfolio

is also important with more schemes now focusing on low risk diversified fund options.

These solutions can also provide trustees with the capability to leverage their exposure using derivatives

through the pooled fund structure. Using funds in this way means that Trustees gain protection but also

free up more cash for investment in higher return generating assets. The broad range of pooled funds

available enables schemes to adjust their strategy with changing market dynamics.

Legal & General Prism will give trustees the ability to see the benefits of allocating assets to different

funds and asset classes whilst also understanding the impact this has on the overall risk and return of

their pension scheme.

The importance of good timing

As some of the governance burden is lifted from smaller schemes through the provision of market

leading analytics in an easy to understand format, the next challenge they face is timing.

A pension scheme’s investment strategy must evolve in order to reduce risk over time. The market

levels at which changes in investment strategy are implemented have a significant effect on the financial

health of a scheme. The higher levels of market volatility since the financial crisis highlights just how

quickly schemes can plunge into deficit. Trustees obviously want to execute their investment strategy

at favourable points in the market cycle. However, it can be difficult for them to respond quickly to

changing investment opportunities due to regulatory restrictions and other demands on their time.

By establishing a series of dynamic triggers (points at which to switch assets), it is possible for pension

schemes to take advantage of attractive market levels and to ‘lock in’ different funding levels.

Enormous flexibility can be offered in terms of the types of triggers that can be monitored. Daily, weekly

or monthly monitoring is available across a huge variety of variables such as equity index levels, bond

yields, swap yields, break-even inflation, credit spreads, relative returns on equities and bonds, and

estimated funding levels for pension schemes.


What the future may hold

As funding levels improve, the next focus for many pension schemes is to think about managing non

investment risk.

For smaller schemes, the financial impact of unexpected changes in the life expectancy of scheme

members can have a particularly significant effect. This is because certain scheme members (for

example the CEO) may account for a major proportion of the liabilities and therefore the risk. In some

schemes, two or three members can represent as much as 40% of total liabilities. A specialist buy-in

strategy, called Large Individual Defined Benefit Annuities (LIDBA) is designed specifically for these

schemes, where risk is concentrated in a few members. It removes the highest risks which in turn

lowers the overall risk level of the scheme.


WHEAT PRICES FORECAST TO RISE 20% ON WIDESPREAD DROUGHTSON THIS DAY 06.06.11

When the world changes, do you change with it?

LGIM has the skills to assess every aspect of your investment strategy and build a solution which meets your needs today and into the future.

We offer a wide variety of liability driven investment (LDI) solutions to help de-risk defined benefit pension schemes and replace them with appropriate defined contribution or workplace savings schemes. Through a range of pooled funds, bespoke unitised funds and segregated solutions we address the needs of clients of all sizes. Our LDI team combines market knowledge and industry experience with an innovative approach to deliver effective solutions.

For more information please contact:

Mike WalshHead of UK Distribution

+44 (0)20 3124 [email protected]

Authorised and regulated by the Financial Conduct Authority.

Wheat prices are driven sharply higher as some of the worst drought conditions for decades coincide across many regions of the world. Further strong gains for wheat prices are forecast by market pundits, on top of the significant increases seen in the preceding six months.

As a source of inflation, rising grain prices force investors to reassess their interest rate expectations, leading to speculation and volatility in financial markets.

LGIM takes a leading role in engineering comprehensive solutions for institutional investors to manage the risks posed by these uncertainties. The strategies it develops are founded upon a deep understanding of the global backdrop and financial markets, as well as detailed insights into each client’s specific objectives.

If you can’t see the big picture, you can’t build

the best solution.

LIABILITY DRIVEN INVESTMENT


Many pension schemes would agree that they should ideally hedge a

greater proportion of the interest rate and inflation risks associated with

their liabilities. These liability-related risks are considered to be unrewarded

risks and it is therefore logical to hedge them.

However, in the current low interest rate environment many pension

schemes are opting not to increase their existing hedges and are instead

continuing to run significant interest rate and inflation risks. In particular,

these schemes are wary of extending existing hedges at a time when both

nominal and real interest rates are close to historical lows, preferring to wait until interest rates rise in

the hope that they can then hedge their risks more cheaply.

Historically low interest rates

In normal market conditions investors expect to earn a yield in excess of inflation from holding fixed

income securities. For example, a nominal yield of 4.5% per annum combined with expected inflation

of 3% per annum leads to a real yield of 1.5% per annum.

However, in recent years nominal interest rates have fallen so low that they stand equal to, or below, the

level of expected inflation, leading to negative real interest rates. For example, as at 28 June 2013 the

yield on the 2022 index-linked gilt stood at minus 0.82% per annum, with the equivalent conventional

Gilt offering a yield of 2.27% per annum. The accommodative monetary policies adopted by central

banks in the wake of the financial crisis, together with exceptional quantitative easing policies have

exacerbated the interest rate compression that started more than 30 years ago. Additionally, despite

a surge in their financing needs, government bonds from countries considered as safe havens have

benefited from huge demand, leading to further downward pressure on yields.

In recent months, interest rates have risen marginally from their historical lows, providing a glimmer of

hope that higher rates may be on the way. However, rates are still only back to levels seen little more

than twelve months ago and real rates remain negative at most maturities. As is often mentioned, the

Japanese experience tells us that rates can stay low for longer than anyone anticipates (see figure 1).

Impact of falling interest rates

Against this backdrop it is perhaps understandable that pension schemes have been nervous about

locking into the prevailing low nominal and real interest rates, only to see them rise at some point in

the future. Unfortunately, over the past few years the historical lows have continued to get lower and

consequently the funding levels of under-hedged schemes have suffered as a result of their inaction.

For example, consider the three-year period ending 31 March 2013. Over that period growth assets

performed strongly, with UK equities returning 27%. However, falling interest rates meant that liabilities

also increased significantly, thus offsetting much of the growth asset gains. We estimate that for a

typical pension scheme, with around 60% in growth assets, the funding level will have fallen by around

5% over the period despite the strong asset performance. At the start of this period many pension

schemes considered that interest rates were already too low and therefore didn’t extend their existing

hedges, but in retrospect to do so would have been very beneficial.

LDI in a low-yield environment

By Howard Kearns, head of LDI, EMEA, investment solutions group, State Street Global Advisors


We would therefore caution pension schemes against basing their hedging strategy solely on the belief

that interest rates must rise at some point. Most people would agree that rates are anomalously low

at present and therefore are likely to rise, but there is no agreement yet on how long they will remain

at the prevailing levels and whether or not they will reach new lows before a meaningful rise occurs.

Rather than do nothing, we would suggest that pension schemes regularly review their hedging

strategy with the aim of ensuring that the scheme is adequately protected regardless of the path that

interest rate and inflation markets take in the future. In particular, rather than simply focusing on what

they believe may be most likely outcome, it makes sense for pension schemes to consider the financial

impact of other potential scenarios.

This is the essence of liability driven investment (LDI), under which all risks are assessed relative to the

liabilities. Using an LDI approach, a pension scheme is able to better understand the potential impact of

the risks that it is taking and so can more easily determine whether or not those risks are appropriate. In

many cases, an LDI analysis would highlight the fact that the un-hedged interest rate and inflation risks

associated with the liabilities dominate the other risks arising from the investment strategy.

Leverage can help

Traditionally, hedging a significant proportion of a scheme’s interest rate and inflation risks would have

meant investing the bulk of its assets in government debt, with only a minimal allocation remaining

for growth assets. This approach is impractical for many schemes as they are under-funded and are

therefore reliant on investment returns to improve their solvency position. In this situation, a leveraged

LDI solution has a role to play. In particular, by committing a relatively small amount of capital to a

Japan’s decades of low interest ratesSource: Bloomberg

2

1

0Apr

19881993 2002

5 yrs Japan

1997 2007 Dec2012

3

4

5

6

7

8

9

GJGB5 Index


leveraged LDI solution, a pension scheme is able to hedge the majority of its interest rate and inflation

exposure, leaving the remainder of its assets free to be invested for growth.

For a typical pension scheme around 40% of the assets would need to be committed to leveraged LDI

in order to hedge the bulk of the interest rate and inflation exposure. The remaining 60% of the assets

could then be invested in a growth strategy aimed at meeting the pension scheme’s funding objectives.

Leveraged LDI strategies allow pension schemes to maximise the amount of assets they are able

to commit to the risks that they expect to be rewarded for taking. In other words, it allows for more

efficient risk taking.

In summary, we would encourage pension schemes to take into account more than just the view

that nominal and real interest rates are likely to rise when setting their hedging strategy. In particular,

pension schemes should fully understand the financial risks that are created when they put this view

into practice. Furthermore, the development of leveraged LDI solutions means that it is now possible

to hedge these risks whilst retaining a significant allocation to growth assets.


1 Pensions & Investments, December 2012. State Street Global Advisors Ltd.State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 2509928. VAT No. 5776591 81. Registered office: 20 Churchill Place, Canary Wharf, London E14 5HJ. Telephone: +44 (0)20 3395 6000. Facsimile: +44 (0)20 3395 6350. Web: www.ssga.com. Investing involves risk including the risk of loss of principal. State Street Global Advisors is the investment management business of State Street Corporation (NYSE: STT), one of the world’s leading providers of financial services to institutional investors. ID2956. EUMKT-2984. Exp. 31/07/2014. © 2013 State Street Corporation – All rights reserved.

Strength and experience.Managing investments in any climate.

With conditions often changing rapidly, investing isn’t all plain sailing.

State Street Global Advisors (SSgA) is one of the world’s leading investment managers because we balance innovation with expertise. Our Liability Driven Investment solutions exemplify this approach.

Our pooled and segregated LDI products combine transparency, flexibility and breadth with expert guidance and service for a complete liability matching solution.

The result? Solutions that aim to protect a scheme’s funding position from the majority of inflation and interest rate risk. So your scheme is free to concentrate on building asset growth in line with its investment objectives.

For more information, contact your SSgA representative.

ID2956_Portfolio Institutional Ad_0713_v1_dv.indd 1 08/07/2013 11:38:50


Editor: Chris Panteli

Deputy editor: Sebastian Cheek

Contributing editor: Pádraig Floyd

Publisher:

portfolio Verlag

Suite 1220 - 12th floor

Broadgate Tower

20 Primrose Street

London EC2A 2EW

This publication is a supplement to portfolio institutional and sponsored by

Legal & General Investment Management and State Street Global Advisors

Contact:

Sidra Sammi

Phone: +44 (0)20 7596 2875

E-mail: [email protected]

Pictures:

Richie Hopson

Printed in Great Britain by Buxton Press

© Copyright portfolio Verlag. All rights reserved. No part of this publication may be reproduced in any

form without prior permission of the publisher. Although the publishers have made every effort to ensure

the accuracy of the information contained in this publication, neither portfolio Verlag nor any contributing

author can accept any legal responsibility whatsoever for any consequences that may arise from errors or

omissions contained in the publication.

ISSN: 2052-0409

Are you interested in participating in future roundtable discussions?

Investors and investment consultants are invited to share their opinion and can be

offered a complimentary place in future roundtable events. Asset managers interested

in joining the panel can secure one of the limited sponsorship packages.

Contact us to find out more.

The next portfolio platform will be held on Friday 06 September

DC investment

Topics for upcoming roundtable discussions:

Emerging markets

Global equities

Smart beta

Liability driven investment - portfolio institutional...Liability driven investment (LDI) continues...

Documents

Transcript of Liability driven investment - portfolio institutional...Liability driven investment (LDI) continues...